The poor performance record of actively managed funds

Most Monevator readers know high costs are the major reason to avoidactive funds, and that low costs are the biggest draw for index trackers.

However paying high fees to managers – as well as all the trading and other expenses racked up by an active fund – wouldn’t matter if they soundly beat the market.

Around here we tend to think of passive investing and index tracker funds as a ménage à deux, but there are plenty of people who invest in active funds who would describe themselves as ‘passive’ investors, too.

They simply put their money into a variety of actively managed funds, and then leave them to get on with trying to beat the market.

But sadly, the reality is few active funds do beat the market after costs, as explained in this Sensible Investing video:

It’s the failure of nearly all active funds to beat index trackers over the long-term that makes active versus passive such an unfair fight.

“Probably about 1% of managers can beat the market over the very long term.”

I wouldn’t call 1/100 anything but exceptionally long odds. Would you?

Are there any good reasons to invest in an active fund?

So as it is, there’s not really any reason to invest in active funds unless:

1) Your sister is a fund manager.

2) Your brother-in-law is a fund manager.

3) You like the romance and colour of active fund management, and you’re happy to pay for it and do worse overall.

4) You want to beat the market and you don’t care that the odds are hugely against you, and you don’t want to pick shares for yourself.

I paraphrase, but that’s the gist.

Now, occasionally a reader will voice a comment saying “it doesn’t have to be either/or”.

And I agree. (Heck, I pick shares for my sins so I can’t be precious).

However you have to be really clear about why you’re investing in active as well as tracker funds.

If you want to juice up your returns, then investing passively in value and other so-called return premiums might do the trick.

If you’re doing it to reduce volatility, then it’d almost certainly be safer and cheaper just to hold fewer equities and more cash and bonds.

If you’re doing it to get overseas exposure, well, you can easily do that through ETFs and trackers.

Some people claim they own active funds for the diversification, which makes little sense given the huge diversification offered by trackers – except to add the few hard-to-reach areas of the market like UK small caps.

Holding 10 active fund managers who invest in UK, US and European large caps is to my mind simply an expensive way of getting tracker-like performance at best, but doing worse after costs.

It doesn’t help that a growing share of active funds are closet trackers to start with.

How I’d invest in active funds

I believe the only reasons for investing in most active funds1 is either because you’ve a sentimental attachment to them (I’m not being facetious – many managers write great narratives about their ultimately fruitless decisions) or because you want to try to beat the market despite the poor chances.

If it’s the latter – and you don’t want to pick shares yourself, and return premiums don’t do it for you – then be smart about how attempt it.

How I’d probably try to go about it is to decide on my one or two very highest conviction active fund ideas (no mean feat, given academics have shown past performance is no clue to future performance) and then invest only in those one or two funds for my active allocation.

I’d then make up the bulk (say 80%) of my equity portfolio with tracker funds.

This way you get a little bit of active fund management colour if you want it, and if they beat the market then you will.

But most of your portfolio will remain pretty cheap, thanks to the trackers, and they’ll likely keep your returns in the same ballpark as the market, too.

Think of your modest allocation to active funds as an indulgence or a folly, like having a pot-bellied pig as a pet.

A bit of fun perhaps, but completely unnecessary, and probably more expensive than you think.

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As opposed to active stockpicking, which is challenging and fun and my own foible. [↩]

Yep, the only active fund I have is UK small caps, as I think the sector is poorly researched and therefore inefficient. For everything else in my portfolio there’s a tracker. I seem to recall reading a piece on HL’s website that the reason there are so few US funds in their wealth 150 was that the market was so well researched and efficient that a tracker was likely to be better. And that was HL!

“you have to be really clear about why you’re investing in active as well as tracker funds”

Does “because I don’t want to be a sheep and blindly follow all this passive investing hype” count as being clear? 🙂

Since reading your blog and reading Tim Hale’s book, I’ve switched most of my active funds to index trackers (only 25% active now). But I don’t want to get rid of all of my active funds just because of what I’ve read in a blog and a book! As with all “advice”, I’m just taking what I want from it and then putting my own personal spin on what I do with it.

Perhaps it is just an indulgence or a bit of fun as you say, or perhaps I believe Neil Woodford will do for his new fund what he did for Invesco Perpetual!

Anyway, I love the pot-bellied pig reference – here’s to my little pig getting nice and fat in the future!

Small cap is probably where you might be able to make an argument. There are not really any small cap trackers in the UK that I am aware of, so the extra management costs may be worth paying depending on the premium paid for small cap.

Having said that I am not sure if most small cap research is based on the USA, and their small cap might be equated to the FTSE250 which can be tracker cheaply.

2/3rds of our stocks are in the main trackers UK and Global.
Use Investment Trusts for less efficient markets where life is more complicated (e.g. Europe, Asia/Pacific/Emerging esp Russia) where hopefully the managers will screen out the dud companies/sectors/countries.

When we see mention of ‘closet tracker’, perhaps as contrarians, we become very interested indeed, providing the TERs are low, to get the desired target market exposure while hopefully screening out the known duds.

For an investor interested in the non-correlated behaviour of commodity stocks, then Investment Trust BRCI found useful. See non-correlated history, and the investor gets a high dividend while waiting for capital gain.

Where tilting to yield Investment Trusts have again proved rewarding.
We had a very bad experience with the high yield emerging market tracker SEDY.

But having said all that, do with caveats very much agree with the main thrust of article.

I understand going with passive index trackers for long term growth, but there appears to be less choice for income drawdown situations. Currently looking for alternatives to IUKD for passive UK equity income’.
Thanks.

@TonyO — Yes, IUKD as I’ve said before is better thought of as a value play IMHO. You could do some research into the UK Dividend Aristocrats tracker (UKDV). The US equivalent has a fair reputation. Remember these sorts of ETFs have no cash buffer, so dividends may rise and fall. You can get around this by creating your own buffer system as I’ve described before.

That said, I think drawdown is a different world to accumulation. In drawdown, I’d probably use income investment trusts if I could get them on a discount, likely starting to build up the portfolio a decade or so in advance by grabbing whatever is cheap looking. (e.g. Some global orientated trusts earlier this year, and emerging market income plays like BRLA and JEMI, again when EMs were hated at the start of the year.)

@Jon
Went into SEDY MY12 with a projected yield of circa 7%, as then suggested by John Baron (Investors’ Chronicle), who to be fair usually sticks to Investment Trusts. The distribution from then on was very rocky, far from predictable, effectively dividend cut, and we bailed out in AU14, probably the worst time, with yield circa 3.5%. John Baron had bailed out earlier without explanation as far as I can recall. We held on thinking we knew better!
So we had a capital loss, and not the expected yield.
Much prefer the smoother dividend distributions of Investment Trusts such as JEMI for emerging markets high yield. Yield is a key measure for us in retirement.

On the subject of active versus passive I remember the AITC (Association of Investment Trust Companies) used to publish a quarterly booklet( free of charge) detailing investment returns for up to ten years on all the member trusts. I remember reading them in the late 1980;s In the UK fund section (which included income and capital growth UK trusts) at the end of the table they included the returns of the FTSE all share. Now the 1980;s were go go years for shares but it always caught my eye that the return on the FTSE all share over a 10 year period beat by a good margin the return on any of the investment trusts invested in the UK.

I’m an active investor, despite all the evidence I happily acknowledge that says I would be better off passive.

Who knows why? Probably because it is just a bit more fun and interesting and the ETF market has not got to the point where you could really play something like a low global value theme properly. The UK listed ETFs for individual countries just aren’t out there yet, nor are they there for properly trying to tap a value, quality and growth combination.

I hold shares and funds but choose my active managers carefully, and like them to have a clear plan and ideally a smaller number of holdings. One reason not to hold an index is that the 20 or 30 best ideas can beat the 100 of everything, at least in my mind anyway. So I like Nick Train, at Finsbury Growth and Income and Terry Smith at Fundsmith.

I think investors can be too loyal though – ride a good manager at the right time all the way up and then all the way back down at the wrong time. My theory is to pick the right fund or trust and manager for the right time and if they don’t have an evergreen idea and the situation moves against them, sell out.

I bought into Fidelity China Special Situations a few months back which has proved a nice little investment, but I would be tempted to sell out when a China bounce back has run its course, whereas with the consumer staple style of Finsbury and Fundsmith I would me more happy buying, holding and adding for as long as they stuck by the plan.

PS. Reading back all of the above has reminded me why I would probably be better off passive investing.

I would ditto comments about Small Cap if you want to go UK only, luckily we have Vanguards Global Small Cap now, although not all platforms have this. I guess if you wanted true UK small cap and can only get this through active if they active fund under performs the ‘equivalent’ index if the return premium invalidated enough for you to forget this asset class? Another area not covered by passive is small value – which US passive advocates do sing praises for.

If active investors (fund managers and private investors) really add no value then we can do without their activities. In that case, how would the efficient market work to allocate capital and how would market-cap weighted funds work?

I have some ideas, but would be interested in yours.

I currently think that market-cap weighted funds specifically should pay some form of levy as they reap a reward from the efficient market while doing nothing to make that market efficient. Kind of like somebody who uses roads, schools and hospitals but doesn’t pay any tax. Those who invest in active funds are the taxpayers in that analogy.

As an Australian I also wonder about small cap.
Both the UK/Europe and Australian Standard & Poor SPIVA scorecards suggest our respective small cap managers have consistently beaten their (perhaps poorly formed) indices. Any thoughts on a framework if you want to, for example, keep some home bias while diversifying away from the typically concentrated large cap indices the UK and Australia seem to have? (Australia has small cap index funds but they consistently underperform their actively managed brethren)

They seem to meet your criteria of “Or maybe where 50% of funds beat the market – but with more volatility, or with fatter ‘tails’ that meant some active funds lost most of your money, but a good proportion spanked trackers.

Then we’d have a really interesting debate on our hands.”

In Australia’s case there are many theories. The old chestnut of small caps being under-researched by institutions due to not being investable in large quantities, the possibility of front-running the index (the small ordinaries index is the bottom 200 of the top 300 so this is plausible), the poor performance of the highest P/B stocks, Resource stocks long-term underperformance. But all these are concocted ex-post. Are the ‘bad’ stocks, whatever they might be, really being just bought up by individual investors and insiders? That seems unlikely given the proportion of our markets owned by funds and other institutional investors.

For reference I’m currently around 95% index tracking as the evidence is strongly in favour of it for large caps globally as well as in Australia.

Taken to its logical conclusion you ought perhaps to subsidizes the brave active investors and traders who are taking all the risk to keep our capitalist system going. I am not sure it would be an election winner though.

If active investors (fund managers and private investors) really add no value then we can do without their activities. In that case, how would the efficient market work to allocate capital and how would market-cap weighted funds work?

This is perennially interesting to me, and for 4-5 years I’ve kept postponing a post about it (“What if everyone tracked the index”) as (I think!) my knowledge has deepened.

I’ve read some research in the past showing only a very small number of active participants are needed to set prices as roughly efficient. I think it’s self evident you’d get more volatility and incorrect pricing as fewer and fewer active investors tried to pin the tail on the donkey, but not sure of the maths.

As an active stockpicker myself I’m all for that. 🙂

Because the issue is also whether you can *capture* any benefit from the less efficient pricing. Remember always that the market *is* the market. The market equals all active investors plus all passive investors. We can essentially net out the passives as following the market, which just leaves the actives.

For them it’s a zero sum game. If there are just two active traders left in the world, one has to lose for the other to win. If you want to be active, you have a 50-50 chance of picking the wrong one. And if there are just two traders left in the world I’m sure they’re going to charge more than passives for the privilege (although that said they would have enormous economies of scale).

That’s the issue, and really why passive is best for most because active can only — as a group — deliver market returns minus higher costs, anyway. Hence you need to be able to identify winners to do it. And virtually nobody can.

I currently think that market-cap weighted funds specifically should pay some form of levy as they reap a reward from the efficient market while doing nothing to make that market efficient.

I have some limited sympathy for that view — though it could be argued that not having millions of clueless mug punters trying to set prices and investing passively instead might actually be making the market more efficient! And perhaps some other millions piling into “hot” active funds near peaks is making it *less* efficient.

But leaving that aside, it’s a bit of a straw man, isn’t it?

Why should a Monevator reader pay a tithe as things stand towards market efficiency? As some sort of noble public good?

Hedge fund managers earning millions a year would be the first to snort at doing it for the average public sector wage I’m sure. 🙂

@John Kingham – thats an interesting point, i doubt such a levy would come to pass though. In the meantime, might as well exploit the scenario as long as it lasts. I wonder what happens as the % passively invested weighted on market cap increases w.r.t. the % actively invested?

On the tax-freeloading point, I often think I would quite like to earn ~10k and as such pay no tax – seems very efficient to me.

I have a vague notion that I wouldn’t feel too guilty about it as I feel like those earning over ~40k (i.e. those who are a net contributor rather than net drain on UK plc in terms of what they cost vs what they contribute in tax) are in the main also ‘superconsumers’ (conspicuous consumption, wasteful use of resources etc.) which could be deemed to be just as unethical as not paying your way with tax.

If you coupled a 10k income with some local community work of some kind I think you would be ok on the ethical side of things

But for sure if everyone did it we would be screwed, just like passive investing.

The beauty is that there is no chance that everyone will decide to earn 10k or invest passively as neither is conducive with human nature

If it was correct that index trackers are making capital allocation somehow less efficient, i.e. passive funds are leading to “mispricing” of assets, it must be implicitly true that there exists a better allocation of capital which active managers can identify. In that case, active managers would capture excess returns on average (i.e. better than the passive allocation).

If active managers can capture excess returns then the passive funds will indeed be paying a “levy”, i.e. lower returns.

The question would remain whether investors in active funds could see any of that excess, or whether it would go to the managers themselves, but, that is less interesting.

a small % of active management is needed to make a market. but it could be a very small % – i see no problem with a large majority of the stock market being held in trackers.

active private investors will always be willing to provide the “service” of making the market. there is no need for the professional active fund managers at all – they didn’t exist when the stock market began.

that said, i don’t expect professional actives to go away. but the total costs of that industry are a few orders of magnitude higher than the value they add; most of the industry should disappear – i.e. there should be a vastly smaller number of managers, managing a lot less money between them but a lot more per manager, at much lower OCFs. this industry are the real freeloaders, not passive investors. and the growth of passive investment is starting to provide competitive pressure to make the active industry slim down.

note that, while active management is a zero-sum game before costs, it’s possible for *professional* active investors to do better than passive, providing that amateur active investors (private investors) are doing worse than passive. (i’m not sure that this actually holds, but it’s a theory.) however, while this might be the case even now, the professional actives handle so much more money than amateurs that any gains they can make at the expense of amateurs will be low per pound they manage, and therefore swamped by their costs. but if the professionals were handling much less money relative to the amateurs, they would have a better chance of adding more money by outperforming the amateurs than they remove in higher costs. so it is even possible that the rise of passive management will make it worthwhile paying for active management – but that’s 1 for the distant future (if ever)!

@grey gym sock, that’s the best argument I’ve heard in favour of passives and I’m included to agree and perhaps ditch my passive levy theory.

The key point is private stock pickers. I had lumped them together in my mind with active fund managers, but private investors don’t charge a fee.

So if we send all the active managers to Mars, then the market would still be made somewhat efficient by private stock pickers and traders (although probably less efficient than professionals) but at no cost. Passive investors then make use of the efficient market without contributing to it, but since nobody paid to make it efficient that seems fair enough to me.

In that case a reasonable outcome is that the market eventually strikes some balance with perhaps 90% in passive cap-weighted funds and the remaining 10% in the hands of private investors (who are generally rubbish at investing) and a few good fund managers who can profit at the expense of the private stock pickers and beat the market even after fees (assuming those fees are reasonable).

The only problem left for the passive ‘race to the bottom’ for fees is its potential impact on stewardship activities. As John Kay said (more or less), passive managers should recognise a special responsibility to improve the performance of the index they track through engaged ownership with the underlying companies as they cannot exit badly managed companies, and as universal owners they cannot escape the environmental or social impacts of wayward companies.

Imagine a country, Passivestan. In Passivestan, all investors are passive, and active investing is illegal. In the 1980’s in the Passivestani stock markets Big Bang, they got rid of all their active investors by putting them in a rocket ship and sending them to Mars. Unfortunately the rocket ship blew up on the launch pad, which is why it is known as the Big Bang.

All Passivestanis invest in the stock market by buying units/shares in index trackers that own the entire Passivestan stock market.

In Passivestan there is no concept of pricing individual shares. Investors judge whether or not to buy index tracking units based on metrics such as the P/E ratio or dividend yield of the index tracking units. In the recent Passivestan market crash, the Passivestan All Share (PAS) dropped to 100 points and had a P/E ratio of 10 and a dividend yield of 5%. Now investor confidence is back, and the PAS has doubled to 200 points with a P/E ratio of 20 and a yield of 2.5%. Investor demand sets the prices of the index tracking units, and the Passivestanis believe they have an efficient market because it is not possible to predict future stock market moves.

Passivestanis believe their system is the best. Attempting to value individual stocks they say is madness since their behaviour is too volatile to allow price to be determined accurately. Leading Passivestani academics theorize that active investing, if it existed would be a zero sum game. Also all that buying and selling of individual shares must be so time consuming and expensive, why not just buy the entire market and have more time to have a beer and enjoy the latest Passivestani TV reality show.

If people are so good at managing funds why would they be working? Wouldn’t they just be able to pick on their own and get rich? Sometimes we try to make investing more complicated than it needs to be. Funds make money whether you do or not…just actively managed ones are going to make more off you than the others.

If you’d like some more incentive for why you’d be better off passive investing take a closer look at Fundsmith’s performance. I did and despite Fundsmith’s claims to the contrary I noticed that it is a closet tracker.

Until my relatively recent conversion to the ‘church of passive’ I held Fundsmith’s Equity Fund. I originally bought it in an ISA because I liked their apparent no-nonsense approach (including their promise of ‘no index hugging’).

I bailed recently because I noticed that over the period I’d held the fund it had in effect tracked the MSCI World Index. On their website they claim to beat this index but during the period I’d held it that wasn’t the case.

So instead of paying 1.16% in fees for Fundsmith I switched to Fidelity’s Index World index tracker to do ostensibly the same job but for an annual fee of just 0.15%.